NEW YORK, 29 September 2003 — The financial markets’goodbye kiss to the strong dollar last week probably will continue to be felt through the US credit markets, causing many money managers to demand higher yields on Treasuries and corporate debt in months to come.
The endorsement by the Group of Seven finance chiefs for more flexible exchange rates implied that foreign governments, particularly in Asia, would let their currencies appreciate, effectively pushing down the greenback.
That complicates the task of financing the deficit in America’s current account, the broadest measure of the nation’s international transactions. That deficit currently is running at a rate of 5 percent of gross domestic product. In dollar terms, that means the US needs to attract $50 billion monthly to balance its payments.
For several years, US has largely depended on foreign purchases of dollar-denominated securities to cover the yawning gap. Over the past year and a half, the US bond market has benefited from the dollars purchased by the Bank of Japan in foreign-exchange interventions aimed at keeping the yen relatively weak. Those dollars have been recycled into the short end of the Treasury market. The notion that this intervention might be curtailed sent the yen surging to 112.21 against the dollar last Monday from 115.24 before the G-7 communique was released.
Before that statement, the 115 was considered to be a break-even exchange rate for Japanese exporters. Now, “rather than defend a specific level of the yen — 115 against the dollar — the BoJ’s aim would be to ensure an orderly appreciation of the yen,” says Mohamed El-Erian, a portfolio manager at Pacific Investment Management, or Pimco, in Newport Beach, Calif.
El-Erian, who spent 15 years at the International Monetary Fund, describes the G-7 communique as “significant” for all economies and financial markets.
Even before the G-7 statement, the Bush administration had been raising concerns about China’s currency, accusing Beijing of keeping the yuan artificially low to gain trade advantages over US-based manufacturers. China has been unmoved by the jawboning; its government policy remains unchanged.
Following release of the G-7 statement, the price of the benchmark 10-year Treasury fell, boosting its yield to 4.218 percent from 4.162 percent previously. However, prices steadied Thursday after a government report showed an unexpected drop in durable-goods orders in August.
Treasuries also got a boost after Robert McTeer, president of the Federal Reserve Bank of Dallas, said Wednesday that the central bank has “plenty of time” before it needs to increase its overnight federal-funds rate, now 1 percent. By Thursday’s close, the yield on the 10-year had dropped back to 4.083 percent.
Nevertheless, given the burgeoning US current-account deficit, “it is understandable that the markets are nervous about the potentially negative impact of dollar weakness” on Asian purchases of Treasuries, agencies and corporate debt, adds El-Erian.
On Monday, the slump in Treasuries triggered selling in the corporate-bond market, too. The spread over Treasuries on Ford’s 5.625 percent notes, due in 2008, widened to 2.45 percentage points from 2.40 the previous trading day.
“It is the first time we find ourselves in an environment of a potential unwinding in the dollar and such large dependence on foreign investors,” remarks Rebecca McCaughrin, an economist at Morgan Stanley.
In fact, she adds, the US was a net creditor nation during much of the dollar’s 1986-1995 decline, so the nation’s dependence on foreigners was much more limited.
Even so, European purchases - most of them are by private investors, not central banks - have been rising, she stresses.
Central banks seek to maintain stability, not maximize profits. Thus, compared with private investors, they’re less prone to reallocate their holdings. Conversely, individuals, who in Japan and Europe have stepped up their purchases of US securities, are total-return investors. Net purchases by foreign private investors accelerated to $148 billion in the second quarter, the highest level in more than 30 years. But now, these investors “are being tested” by the likely further decline in the greenback, McCaughrin observes.
